Financial Institutions And Financial Markets

Front 1

What are financial institutions and markets?

Back 1

Financial institutions and markets are the channels through which saving finances the investment in new capital, that makes the economy grow.

Front 2

What is finance?

Back 2

Finance is the activity of borrowing and lending, which provides funds that finance expenditures on capital (productivity grows as a result).  The study of finance examines how households, firms and governments obtain and use financial resources, and how they cope with the risks that arise in this activity.

Front 3

What is money?

Back 3

Money is used to pay for goods and services, factors of production (expenditures on new capital), and financial transactions (receive and repay loans).  The study of money examines how households and firms use money, how banks create money and manage it, and how the quantity of money influences the economy.

Front 4

What is physical capital?

Back 4

The tools, instruments, machines, buildings and other items that have been produced in the past, and which are used today to produce goods and services.  Inventories of raw materials, semi-finished goods and components are part of physical capital.

Front 5

What is financial capital?

Back 5

Financial capital – Funds used to buy physical capital.  In the aggregate production function, as quantity of capital increases, the curve shifts upwards.  Investment, saving, borrowing and lending decisions influence the quantity of capital and can make real GDP grow.

Front 6

What is investment?

Back 6

Investment increases the quantity of capital.  Depreciation (from wear and tear, and obsolescence) decreases the quantity of capital.  Gross investment – Total amount spent on new capital.  Net investment – Change in value of capital. 𝑁𝑒𝑡 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝐺𝑟𝑜𝑠𝑠 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 − 𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛

Front 7

What is wealth?

Back 7

The value of all things that people own. Wealth increases when savings increase.  Wealth increases/decreases when the market value of assets rises/falls (capital gains/losses).

Front 8

What is saving?

Back 8

The amount of income that is not paid in taxes or spent on consumption goods and services. Saving is the source of funds used to finance investment.  The funds are supplied and demanded in three financial markets.

Front 9

Describe loan markets

Back 9

Bank loans can provide businesses with short-term finance to buy inventories, or extend credit to customers.  Households may want finance to purchase a high expenditure item (e.g. a car, household furnishings and appliances), by getting a bank loan in the form of outstanding credit card balances  Households can get finance to buy new homes, obtained as a loan that is secured by a mortgage.

Front 10

What is a mortgage?

Back 10

A legal contract that gives ownership of a home to the lender in the event that the borrower fails to meet the agreed loan payments (repayments and interest).

Front 11

What is a bond?

Back 11

A promise to make specified payments on specified dates.  National and local governments raise finance by selling bonds to the public

Front 12

What are bond markets?

Back 12

Where bonds issued by firms and governments are traded.  A person may hold a bond until the borrower has repaid the amount borrowed or sold it to someone else.  The term of a bond may be long (decades) or short (couple of months).  A firm may issue a short term bond (commercial paper) as a way of getting paid for their sales before the buyer is able to pay. The seller would get the full payment immediately, and the bank would get the payment (and extra) when the buyer honours their promise in the future. (UK Treasury offers this type of promise as Treasury Bills)

Front 13

What is mortgage backed security?

Back 13

A bond which entitles the holder to the income from a package of mortgages.  Mortgage lenders create mortgage-backed securities.

Front 14

What is stock?

Back 14

A certificate of ownership and claim to the firm’s profits, which are paid out as dividends.

Front 15

What are stock markets?

Back 15

A financial market in which shares of stocks of corporations are traded. E.g. London Stock Exchange.  Unlike bondholders, stockholders own part of the firm.  There is no guarantee that stock prices will rise.

Front 16

Define: financial institution

Back 16

A firm that operates on both sides of the markets for financial capital.  It is a borrower in one market and a lender in another.  They stand ready to trade, so households with funds to lend and firms or households seeking funds can always find someone on the other side of the market with whom to trade.  There are 4 key financial institutions.

Front 17

What is a commercial bank?

Back 17

Financial institutions that accept deposits, provide payment services, and make loans to firms and households.  They play a central role in the monetary system.

Front 18

What is a mortgage company?

Back 18

Financial institutions that specialise in making loans for property purchases.  Loans for house purchase are packaged into mortgage-backed securities and sold to banks.  The holder of a mortgage-backed security bond is entitled to receive payments that derive from those received by the mortgage lender from the homeowner-borrower

Front 19

What is a pension fund?

Back 19

Financial institutions that use pension contributions of firms and workers to buy bonds and stocks (which also hold mortgage-backed securities).  Some pension funds are very large and play an active role in the firms whose stock they hold.

Front 20

What are insurance companies?

Back 20

Financial institutions that enable households and firms o cope with risks (e.g. accident, theft, fire).  They receive premiums from their customers and pay claims.  They use funds they have received but not paid out as claims to buy bonds and stocks on which to earn interest income.

Front 21

What is net work?

Back 21

The market value of its assets (lent) minus the market value of its liabilities

Front 22

Relationship between net worth and solvency and liquidity

Back 22

If net worth is positive/negative, the financial institution is solvent/insolvent.  A firm is illiquid if it has made long-term loans with borrowed funds and is faced with a sudden demand to repay that it cannot meet with cash.  If all financial institutions are short of cash, the market for loans among financial institutions dries up; only the central bank can provide funds.

Front 23

What do financial assets include?

Back 23

Financial assets include stocks, bonds, short-term securities and loans.

Front 24

What is the interest rate on a financial asset?

Back 24

The interest rate on a financial asset which pays interest is: 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑅𝑎𝑡𝑒 = 100 ×𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑃𝑎𝑖𝑑 𝐴𝑠𝑠𝑒𝑡 𝑃𝑟𝑖𝑐𝑒  If the asset price rises/falls (other things remaining the same), the interest rate falls/rises.  If the interest rate on the asset rises, the price of the asset falls, debts become harder to pay, and the net worth of the financial institution falls.  Insolvency can arise from a previously unexpected large rise in the interest rate.

Front 25

What is the loanable funds market?

Back 25

The aggregate of all the individual financial markets.  Funds that finance investment come from three sources: o Household saving – Household income (𝑌) spent on consumption goods and services (𝐶), saved (𝑆), or payed in net taxes (𝑇). o Government budget surplus – Aggregate expenditure (𝑌) from previous chapters. o Borrowing from the rest of the world

Front 26

Define: net taxes

Back 26

The taxes paid to governments minus cash transfers received from governments, 𝑇 (e.g. benefits). 𝑌 = 𝐶 + 𝑆 + 𝑇 𝑌 = 𝐶 + 𝐺 + 𝐼 + 𝑋 − 𝑀 𝐼 = 𝑆 + (𝑇 − 𝐺) + (𝑋 − 𝑀)  The third equation happens when equating the first two equations. Investment (𝐼) is financed by household saving (𝑆), government budget balance (𝑇 − 𝐺), and borrowing from the rest of the world (𝑋 − 𝑀).

Front 27

What is national saving?

Back 27

The sum of private saving (𝑆) and government saving (𝑇 − 𝐺) 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 = 𝑁𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝑆𝑎𝑣𝑖𝑛𝑔 + 𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑡𝑖𝑜𝑛𝑎𝑙 𝐵𝑜𝑟𝑟𝑜𝑤𝑖𝑛𝑔  𝑇 > 𝐺 (Government budget surplus) contributes funds to finance investment.  𝑇 < 𝐺 (Government budget deficit) competes with investment for funds and decreases the amount available to invest.

Front 28

What is nominal interest rate?

Back 28

The number of pounds that a borrower pays and a lender receives in interest in a year expressed as a percentage of the number of pounds borrowed and lent.

Front 29

What is real interest rate?

Back 29

The nominal interest rate adjusted to remove the effects of inflation on buying power (approximately equal to 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒).  I.e. the real interest rate is the additional goods and services that the lender can buy with the interest received.  The real interest rate is the opportunity cost of loanable funds. Real interest paid on borrowed funds is the opportunity cost of borrowing.  The loanable funds market determines the real interest rate, the quantity of funds loaned, saving and investment. o Demand for loanable funds. o Supply of loanable funds. o Equilibrium in the loanable funds market.

Front 30

what is demand for loanable funds?

Back 30

The relationship between quantity of loanable funds demanded and the real interest rate, when all other influences on borrowing plans remain the same.  The main source of demand for loanable funds is business investment, which is influenced by two factors: o Real interest rate – As the real interest rate rises/falls, quantity of loanable funds demanded falls/rises, because it becomes more costly/cheaper to borrow. o Expected profit – Greater expected profit from new capital means greater demand for loanable funds, as the amount of investment is greater

Front 31

What is the supply of loanable funds?

Back 31

The relationship between quantity of loanable funds supplied and the real interest rate, when all other influences on lending plans remain the same.  The main source of supply of loanable funds is saving, influenced by (if other factors remain the same): o Real interest rate – A rise/fall in the real interest rate increases/decreases the quantity of loanable funds supplied because lending is more/less attractive. o Disposable income – When disposable income increases/decreases, both saving and consumption expenditure increase/decrease. So the more/less disposable income a household has, the greater/smaller the saving. o Expected future income – The higher/lower a household’s expected future income, the smaller/bigger its saving today. o Wealth – The higher/lower a household’s wealth, the smaller/larger its saving. o Default risk – The risk that a loan will not be repaid. If risk is large/low, the interest rate must be higher/lower to induce a person to lend and the smaller/bigger the supply of loanable funds.  An increase in saving is an increase in the supply of loanable funds.

Front 32

What is equilibrium in the loanable funds market?

Back 32

When the demand for loanable funds curve (𝐷𝐿𝐹) and the supply of loanable funds curve (𝑆𝐿𝐹) intersect, the loanable funds market is at an equilibrium.  This occurs at one real interest rate and one quantity of loanable funds.  Whether there is a surplus or shortage of loanable funds, the real interest rate is pulled towards the equilibrium interest rate.  Financial markets are highly volatile in the short-run, due to fluctuations in demand or supply of loanable funds.  They are remarkably stable in the long run

Front 33

When does a government influence the loanable funds market?

Back 33

Government influences the loanable funds market when it has a budget surplus or deficit.

Front 34

Government budget surplus and loanable funds market

Back 34

Government budget surplus increases supply of loanable funds.  𝑃𝑆𝐿𝐹 is the private supply of loanable funds, and 𝑆𝐿𝐹 is the supply of loanable funds.  In government budget surplus, supply of loanable funds exceeds the private supply of loanable funds.  𝑆𝐿𝐹 > 𝑃𝑆𝐿𝐹.  Real interest rate falls, decreasing household saving and decreasing quantity of private funds suppled.

Front 35

Government budget deficit and loanable funds market

Back 35

Government budget deficit increases demand for loanable funds.  𝑃𝐷𝐿𝐹 is the private demand for loanable funds, and 𝐷𝐿𝐹 is the demand for loanable funds.  In government budget deficit, demand for loanable funds exceeds private demand for loanable funds.  𝐷𝐿𝐹 > 𝑃𝐷𝐿𝐹.  Real interest rate rises, increasing household saving and increasing quantity of private funds suppled.

Front 36

Define: Crowding-out effect

Back 36

The tendency for the government budget deficit to raise the real interest rate and decrease investment  When government expenditure rises or taxes are cut, the budget balance becomes a budget deficit.  Demand for loanable funds curve shifts to the right (as in graph above), raising real interest rate and increasing private saving.  The rise in real interest rates leads to crowding out; investment reduced, but by less than the increase in budget deficit.

Front 37

Define: Ricardo-Barro effect

Back 37

Government budget has no effect on real interest rates and investment. This doesn’t agree with the crowding-out effect, arguing that rational taxpayers see that a budget deficit implies higher future taxes, and save to support their future consumption needs. This increase in private saving offsets the reduction in public saving, so interest rates and investment are unchanged (seen in graph on right).